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Tuesday, July 1, 2014

Disclaimer: This article does not represent advice to invest in UOA
REIT or to use margin financing. This is my first time using margin financing
and my understanding of how things work may be flawed. There may also be errors
in my analysis, calculations and other errors. Do your own damn research and take responsibility
for your own damn investments.

I
recently decided to use margin financing to try to unlock some hidden value in
my portfolio. I still have positions in 2 Malaysian stocks (my margin facility
doesn’t accept foreign shares as collateral) which I think will perform
decently over the long-term. However, I could get even more value out of my
Malaysian shares by pledging them as collateral to get some financing. As I
only have a small margin facility, the effective rate that I got was around 5.76%
which isn’t great but it isn’t too bad either as I’m just experimenting with a
small amount of debt. The effective rate drops to a pretty reasonable 4.71%
if I have a larger margin facility and borrowed more. Just like how a kid
starts off with a Happy Meal before moving on to a Double Quarter Pounder set,
I need to start out small and learn how to effectively utilize debt. Before I
continue, I would like to bring you guys a quick update on the Greedy Dragon
Portfolio. Apart from investing in UOA REIT, I also sold my shares in Overseas
Education Limited as it went up quite a bit since I bought it and I wanted to
increase my cash holdings.

Anyway,
I figured that if I could find an investment with a higher income yield than the
margin loan’s interest cost, I could increase the cash my portfolio generates
every year. I also needed to be confident that the investment’s yield is
sustainable or I could find my margin financing strategy turning cash flow
negative.

There
weren’t many investments in Malaysia that had a high enough yield to pay off
the interest and still have a little somethin’ somethin’ left over for me.
However, I did manage to find UOA REIT which I think is a suitable candidate
for this margin financing strategy. I invested in the REIT at Ringgit Malaysia
(RM) 1.39 per unit. UOA REIT has a portfolio of office buildings located in
Kuala Lumpur, the capital city of Malaysia. Based on the 2013 distributions per
unit, the REIT’s after tax distribution yield of 6.91% is high enough that I can
still service my debt if the REIT experiences a small drop in earnings and
distributions. You don’t want to be in a situation where the spread between the
investment’s distributions and the debt’s interest is like a dollar; you need a
margin of safety. According to the 2013 annual report, UOA REIT’s properties
also have pretty high occupancy rates of between 87.3%-98.5% which should
increase the odds of the REIT being able to maintain the rental it charges its tenants.
Another advantage of investing in REITs with this strategy is that REITs are
required by law to distribute most of their earnings. So, unless a REIT starts
making losses, investors should still receive some income even during
downturns.

Note: According to this
article in The Star, Malaysia REIT’s distributions will be taxed at the
lower 10% rate for local and foreign retail investors until at least 31
December, 2016. I don’t know much about tax laws, so please do your own
research or consult a tax expert before making any investments.

I
also tried to reduce my risk to a very low level with this position as I don’t
want to end up being my bank’s boy. One of the main risks of margin financing
is that interest rates might rise and result in the cost of servicing the debt
being higher than the income from your investment. Interest rate risk is very
low for my position as my cash holdings are large enough that I can easily pay
off my margin loan anytime; I also have cash inflows from other sources that
can be used to service the debt. Another risk of margin financing is of course
the dreaded margin call where your position can get wiped out if you don’t top
up your account. I mitigated this risk by over collateralizing so something really
bad would have to happen before my ass gets margin called. A major risk for
this specific position is that there might be a supply glut in Kuala Lumpur office
space for a while. However, I think that even if UOA REIT’s occupancy rates and
rental rates do come down a bit, it should still be at a healthy level in the
near future.

To
further reduce risk, I will set aside RM 1,441.15 in cash (2 years of
interest payments) specifically to help me meet interest payments in case this
position turns cash flow negative and I decide to wait on a recovery. Any
positive cash flows (and I hope the cash keeps rolling in) will be used to reduce
the debt or replenish the cash buffer if I had to tap into it in previous
periods. The idea over the long-term is to pay off the debt using the cash
generated by the REIT and convert the position into pure, yummy, delicious
equity.

A
good scenario to use this margin financing strategy would be when there are
opportunities to invest in assets with 9%-10% yields. If I find myself in such
a situation and my capital structure can afford the extra debt, then I might
take a margin loan large enough to get the lower interest rate of 4.71%
(assuming that the base lending rate stays the same). However, I think that
financing some UOA REIT units with a margin loan is alright for my portfolio. This is the case as the
debt that I took on is small relative to my portfolio’s size. I’m also treating
this position as a learning experience to build up my competence in debt and
cash flow management. I also think that buying units of UOA REIT on margin at
its current price actually creates value for my portfolio. The following table
breaks down the returns that I could potentially earn assuming that UOA REIT’s distributions
per unit and the base lending rate stay at current levels:

Cash buffer

RM 1,441.15

Borrowings

RM 12,510

Effective Interest

5.76%

After tax yield

6.91%

Interest cost

RM 720.57

Income distributions

RM 864.27

Net cash inflow

RM 143.69

Cash on cash return

9.97%

1Cash on
cash return = Net cash inflow/cash buffer

2Again, the
cash buffer represents the cash set aside specifically for this position and
not my total cash holdings.

Whatever
positive cash flow I get, I’m using to pay down the debt which gives me a
reinvestment rate of 5.76% (not bad in this market, not bad at all). Really
awesome things start to happen if UOA REIT is able to increase its
distributions and/or if there’s an increase in the market price of the REIT’s
units. If UOA REIT is able to boost its distributions per unit by 10%, the
annual cash-on-cash return should increase to 15.97%. A 10% gain in the REIT’s
unit price should result in about an 87% return on the cash buffer.
I’m not taking this position with
the expectation that UOA REIT will increase its distributions or that the price
of its units will rise (although I think both of these things are likely to
happen in the long-term).

Before
I end this article, I would like to advice you guys to never take on debt for investing if you don’t understand debt and
cash flow management. And even if you think that you can manage debt and cash
flows well, don’t ever take on too
much debt and put yourself in a position where your financial future is at risk
of getting bitched out by a margin call. Thank you for reading. Take care and
stay rational.